Using Sec. 338 to Avoid Anti-Churning Rules

When assets are sold in
a taxable transaction, the buyer must be aware of
limitations placed on amortizing certain acquired
intangibles under the anti-churning rules in Sec.
197(f)(9). A recent letter ruling highlights the
ability to use a Sec. 338 election to create the
effect of an asset sale while avoiding the
anti-churning rules.

The IRS ruled that the contribution followed
by the prearranged sale of the preferred stock
was a taxable sale of the Sub 1 stock under Sec. 1001. The letter ruling
also concluded that assuming a Sec. 338(h)(10)
election is made with respect to Sub 1, Sub 1 Subsidiaries, Sub 7, and Sub 7 Subsidiaries, any goodwill, going-concern value, and
other Sec. 197 intangibles (for which
amortization would not have been allowable but
for Sec. 197) of Sub 1, Sub 1 Subsidiaries, Sub 7, and Sub 7 Subsidiaries are not subject to the anti-churning rules
of Sec. 197(f)(9).

Qualified Stock Purchase

A Sec. 338 election is permitted only if
there is a qualified stock purchase (QSP). A QSP
is a transaction, or series of transactions
within a 12-month period, in which a corporation
purchases at least 80% of the voting power and
value of the stock of another corporation (Sec.
338(d)(3)).

Stock is not considered
purchased if it is acquired in a Sec. 351 or Sec.
354 transaction (Sec. 338(h)(3)(A)(ii)). In the
letter ruling, the contribution was not a Sec. 351
transaction because immediately after the
contribution, taking into account the binding
obligation, Distributing
did not own any Corp 1
preferred stock and thus was not in control of
Corp 1
(Sec. 368(c)). The contribution was not a B
reorganization, because Corp 1 issued
nonvoting stock (Sec. 368(a)(1)(B)).

Stock
also is not considered purchased if it is acquired
from a related person. A seller generally is
related to the purchaser if stock owned by the
seller would be attributed to the purchaser under
Sec. 318(a) (Sec. 338(h)(3)(A)(iii)). The key to
determining relatedness is the time for
testing:

In the case of a single
transaction, test immediately after the purchase
of target stock;

In the case of a
series of acquisitions otherwise constituting a
QSP, test immediately after the last acquisition
in the series; and

In the case of
a series of transactions effected pursuant to an
integrated plan to dispose of target stock, test
immediately after the last transaction in the
series (Regs. Sec. 1.338-3(b)(3)).

When Corp
1 acquired Sub 1, Distributing’s
ownership of Sub
1 would have been attributed to Corp 1 under
Sec. 318(a) because Distributing
owned more than 50% of Corp 1.
However, as part of the same plan, Distributing
severed its relationship with Corp 1.
Immediately after the spinoff, Distributing
and Controlled each
were publicly traded, Controlled
owned the Corp
1 common stock, and the insiders and
investors owned the Corp 1
preferred stock. Consequently, Corp 1
purchased the Sub 1
stock.

anti-churning Rules

A Sec. 338 election in effect converts a stock
purchase into an asset purchase. A fictional “old
target” is deemed to sell all its assets subject
to its liabilities to a fictional “new target.”
This deemed asset sale raises anti-churning
concerns.

The anti-churning rules in Sec.
197(f)(9), which were enacted on Aug. 10, 1993,
are designed to prevent the amortization of
intangibles if they were unamortizable under prior
law, unless the ultimate user of the intangibles
changes. In general, goodwill or going-concern
value acquired after that date is not amortizable
if:

The taxpayer or a related
person held or used the intangible during the
transition period (July 25, 1991, to Aug. 10,
1993);

The taxpayer acquired the
intangible from a person that held the
intangible at any time during the transition
period and, as part of the transaction, the user
of the intangible does not change; or

As part of the same plan as the acquisition,
the taxpayer grants the right to use the
intangible to a person (or person related to
that person) that held or used the intangible
during the transition period.

For this purpose, two persons are related
if, among other relationships, one bears a
relationship to the other that is specified in
Sec. 267(b), substituting 20% for 50% for the
ownership thresholds (Regs. Sec.
1.197-2(h)(6)(i)(A)). This includes two
corporations in a parent-subsidiary controlled
group connected by more than 20% voting power or
value (Secs. 267(b)(3) and 267(f)). Relatedness
is tested under Sec. 197(f)(9) and Regs. Sec.
1.197-2(h)(6)(ii):

In the
case of a single transaction, immediately before
or after the transaction in which the intangible
is acquired; and

In the case of a
series of related transactions (or a series of
transactions that comprise a QSP), immediately
before the earliest transaction or immediately
after the last transaction.

Planning Using a Sec. 338
Election

Why did the IRS rule that the anti-churning
rules would not apply to the deemed asset sale
if old target and new target are the same legal
entity? When a Sec. 338 election is made for an
acquisition after Aug. 10, 1993, the Sec. 197
related-person rules are bypassed and new target
is deemed not to be the person that held or used
the assets during any period in which the assets
were held or used by the old target (Regs. Sec.
1.197-2(h)(8)). In the letter ruling, the
taxpayer structured the transaction into a QSP
with a Sec. 338 election in order to recognize
losses and to be able to amortize the remaining
basis in the assets. If a Sec. 338 election had
not been made, Distributing would have recognized only the loss in the
stock of Sub 1, if any, and Corp 1 would have had no new amortizable asset
basis after it was spun off by Distributing.

What’s the
Catch?

The anti-churning rules still may apply to a
deemed asset sale if new target is related to
old target within the meaning of Regs. Sec.
1.197-2(h)(6). For example, if (1) individual A owns 25% of the stock of each of P and T, (2) P makes a QSP of T from shareholders A and B in July 2000, and (3) P makes a Sec. 338 election, old target and
new target would be members of a controlled
group under Sec. 267(b)(3) (as modified to
reflect 20% ownership). Therefore, any
nonamortizable Sec. 197(f)(9) intangible held by
old target would not be an amortizable Sec. 197
intangible in the hands of new target (Regs.
Sec. 1.197-2(k), Example (23)). Contrast this
example with the letter ruling in which
affiliation between old target and new target
for Sec. 197 purposes was severed with the
spinoff, with the result that new target was not
related to old target after the series of
related transactions.

EditorNotes

Annette Smith is a partner with PwC, Washington
National Tax Services, in Washington, D.C.

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